Energy Companies Face Crude Reality: Better to Leave It in the Ground

A new era of low crude prices and stricter regulations on climate change is pushing energy companies and resource-rich governments to confront the possibility that some fossil-fuel resources are likely to be left in the ground.

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In a signal that the threat is growing more serious, Exxon Mobil Corp. (XOM) is expected in the coming week to disclose that as much as 3.6 billion barrels of oil that it planned to produce in Canada in the next few decades is no longer profitable to extract.

The acknowledgment by Exxon, after the company spent about $20 billion to put the oil sands at the center of its growth plans, highlights how dramatically expectations have changed about the future prospects of the region.

Once considered a safe bet, Canada's vast deposits are emerging as among the first and most visible reserves at risk of being stranded by a combination of high costs, low prices and tough new environmental rules.

"For a lot of reasons the oil sands look like a prime candidate for eventual abandonment," said Jim Krane, an energy fellow at Rice University's Baker Institute. "One problem is that costs are persistently higher. The high carbon content only makes it worse."

During most of the past decade, Exxon and other giant oil companies spent billions of dollars in Canada as part of a global quest for new sources of supply, as analysts cautioned about "peak oil," or the risk of running out of the resource. Prices surged to $140 a barrel.

Companies were driven in part by the need to replenish their reserves of oil and gas, since investors have traditionally looked at such numbers as an important barometer for a resource company's future.

But now, the worry is more about "peak demand." Amid a glut of supply that led to a price collapse in 2014 and a tepid recovery, investors and executives at some of the world's biggest energy producers are considering the possibility that oil demand could peak and then slow in the coming decades.

The shift from a preoccupation with insufficient supply to worries about demand has altered investment priorities away from high-cost opportunities in the Arctic, ultra-deep waters and the oil sands.

Such projects can require billions of dollars in upfront investment and seven to 10 years, or more, to bring returns. Instead, companies are increasingly focusing on new sources of crude oil, such as shale, that don't require the same massive investment and that can get from development to production much more quickly.

"Barring some geopolitical catastrophe that really changes the outlook...all these other projects are going to take the wind out of the oil sands," said Amy Myers Jaffe, executive director for Energy and Sustainability at University of California, Davis.

Canada was once thought to hold the world's third-largest trove of crude, enough to meet U.S. demand for almost 30 years, largely due to the oil sands in northern Alberta -- giant deposits of crude with the consistency of a hockey puck.

Today, only about 20% of those reserves, or about 36.5 billion barrels, are capable of being profitable, according to energy consultancy Wood Mackenzie.

In the decade leading up to the 2014 price collapse, companies spent as much as $200 billion building megaprojects to extract heavy oil in Alberta's boreal forest.

Canada, despite its high costs, was attractive to companies like Exxon for its stability and proximity to the U.S.

To build its Kearl oil sands project in Alberta, Exxon invested more than $20 billion, designing a less carbon-intensive process by which the oil could be extracted without use of a high-emitting plant called an upgrader.

The project was supposed to unlock 4.6 billion barrels of crude over 40 years. First production came online in 2013 and was expanded significantly two years later. The plant produced an average of about 169,000 barrels a day last year, according to an Exxon subsidiary.

The plant now produces approximately 300,000 barrels a day, according to Exxon.

The lost reserves are a casualty of the price collapse that has led more than 17 oil sands projects, representing about 2.5 million barrels a day of production, to be canceled or delayed, according to ARC Financial Corp.

Global companies such as Statoil ASA (BEXP) and Royal Dutch Shell PLC (RDS) that raced to build massive industrial projects in Canada have been forced to write down the value of oil sands investments. Since 2012, the write-downs from those companies and Canadian producers have exceed $20 billion.

Exxon is expected to drastically reduce its oil sands reserve tally, but has stopped short of taking any financial write-down on its Canadian assets. The company has said it continues to expect that the reserves will be developed. Exxon also doesn't foresee an oil demand peak in its forecasts through 2040.

"Even though we make that transfer, there is no change to our operations or how we manage the business, those assets going forward," Jeff Woodbury, Exxon's vice president of investor relations, told investors last month.

U.S. Securities and Exchange Commission rules require companies to evaluate their future prospects based on the average oil price in the previous year -- about $43 a barrel in the U.S. for 2016. Exxon has said it may take as much as 3.6 billion barrels off its books because they lose money at low prices. The reserves may be added again if prices rise, costs fall or operations become more efficient, Exxon has said.

Exxon isn't the only company taking steps that underscore the new realities and threats to future oil reserves. In its annual energy outlook published earlier this year, BP warned that an abundance of already-discovered oil resources and a slowdown in the pace of demand growth will likely mean some barrels are never recovered.

Exxon, along with Chevron Corp. (CVX), is pouring billions into expanding their footprint in shale oil, turning to projects that can ramp up quickly to fill the void left by a lack of larger, costlier developments.

Many of Canada's biggest producers are planning to spend less or keep expenditures roughly flat this year compared with 2016, even as spending in parts of the U.S. is starting to rise.

According to the Canadian Association of Petroleum Producers, capital investment in the oil sands tumbled around 30% in both 2015 and 2016 and is expected to slide another 11% this year.

To be sure, oil output isn't expected to fall in Canada as it has in the U.S., and some projects for which money has already been spent may go forward, a sign of the resilience of oil sands investments once money has been spent. That is because the cash cost of producing barrels once projects are up and running is low.

In addition to the oil sands' high costs, extracting and refining the region's heavy oil or bitumen is on average a more carbon-intensive process than almost any other type of extraction. The Alberta and Canadian governments have introduced new rules, including a cap on emissions and a carbon tax.